Market Views Opinions, Rants and Raves

Equity markets were up markedly in the third quarter with the S&P 500 delivering a total return of 6.4% for the quarter and 16.4% for the year to date. This is rather surprising given the macroeconomic and political uncertainty facing investors in the U.S. The upcoming election, so called “fiscal cliff” and ongoing turmoil in Europe have provided ample reasons for investors to shun riskier assets this year, but equity returns have so far been able to climb the wall of worry that has been firmly in place throughout the year, fueled in part by ultra-low interest rates and meager bond yields.

The art and science of constructing investment portfolios is comprised of two distinct, but interrelated disciplines. Asset allocation deals with stocks, bonds, real estate and other types of investments at the aggregate level and assigns percentages of the portfolio to these various asset classes based on a client’s risk profile. The allocated percentages to each asset class determine the parameters of a portfolio’s overall performance as it is nearly impossible to overcome the gravitational pull of an asset class return if it is a large enough percentage of the portfolio. For example, the potential range of returns available to a portfolio comprised of 80% bonds and 20% stocks is much narrower than a portfolio of 80% stocks and 20% bonds. An asset class with a large enough percentage allocated in the portfolio will by and large determine the return characteristics of that portfolio. The second component of portfolio construction is individual security selection with the attendant challenge of assembling a collection of stocks, bonds or other securities that have materially different return characteristics than one of the fund offerings that exist today. Many investors have thrown up their hands in frustration at trying to differentiate between the thousands of mutual fund offerings available to them and have opted to use low-cost, index-tracking funds for asset class exposures instead. This works well most of the time for most people and is a cost-effective way to build an investment portfolio. The success of low-cost asset class exposure as a strategy is evidenced by the $115 billion under management at State Street’s S&P 500 index-tracking fund, the largest exchange-traded fund by assets.

The case for building an investment portfolio with low-cost index funds is compelling. The case for using the S&P 500 as the reference to which the largest funds are indexed is less so. The Standard and Poor’s 500 index is constructed by assigning weights to the 500 individual stocks in the index by each company’s market value. Problems occur with this weighting methodology when sectors of the economy experience unsustainable growth and tend to reach their highest weightings at the peak of their growth curve. Two recent examples include the technology bubble of the 1990’s and the housing bubble of the 2000’s. The index weighting for the technology sector reached 29% in 1999 and fell to 14% in 2002, while the financial sector peaked at over 22% of the index in 2006 and fell to less than 9% during the depths of the financial crisis. This pro-cyclical weighting methodology has cost S&P 500 index-fund investors upwards of 7% annually in lost performance gains over the last 12 years. Exposure to the financial sector alone has cost 3% a year over the last 5 years. In contrast, our weighting methodology for equity asset class exposure is based on fundamental analysis of individual companies and the drivers of sustainable earnings and dividend growth. This process has allowed us as investment managers to avoid the pro-cyclical issues associated with a market value weighting methodology.

Financial markets experienced another volatile quarter in Q2. The continuing European banking and sovereign debt problems are depressing growth globally and have subtracted more than 50 billion dollars from corporate profits so far this year for multinational firms in the U.S.1 The interconnected movements of capital and commerce are here to stay and a disruption in one region of the world is quickly transmitted to every corner of the globe. The distinction between events that occur in Athens, Greece or Athens, Georgia is no longer based on the location, but rather the impact on global financial markets. We believe that the best investment performance in this environment continues to be driven by fundamental principles of value creation achieved through diligent research and implemented consistently across asset classes (stocks, bonds, etc.). Our goal is to deliver consistent results over the long-term by reducing volatility in the near-term and focusing on the investment options that have the highest probability of delivering these results.

The first three months of 2012 marked the highest first-quarter return for the S&P 500 index since 1998 with a total return of 12.6%. The best performing sectors were Financials (21.5%), Information Technology (21.1%) and Consumer Discretionary (15.5%). The Utilities sector was the only index component delivering a negative return for the quarter, losing 2.7%.1

Bull markets don’t start at fair value. They start when a majority of stocks are selling at a significant discount to fair value. There have been time periods in the last 70 years when the stocks in the S&P 500 index were valued in the single digits on average, notably in the late 1940’s to early 1950’s and the late 1970’s to the early 1980’s. Low valuations turbocharged stock returns as they multiplied earnings growth, expanding from undervalued to overvalued in the process.

Bear markets don’t start at fair value. They start when a majority of stocks are selling at a significant premium to fair value. There have been time periods in the last 90 years when the stocks in the S&P 500 index were valued at more than 25 times earnings on average, notably in the late 1920’s and the late 1990’s. High valuations compressed stock returns as they overwhelmed earnings growth, contracting from overvalued to fair value (or undervalued) in the process.

Sideways markets start at fair value. Valuations expand and contract within one standard deviation of their long-term average (16 times earnings +/- 6.5) and stock returns bounce around from year to year, sometimes a bit negative and mostly a bit positive. This was the case between 1955 – 1972 before double-digit inflation pushed stocks into bull market territory.

At 14 times earnings, today we are squarely in a sideways market and will stay there until something really bad happens (high inflation leading to an extremely discounted market) or people lose their minds again and send valuations into the stratosphere. Strategies that maximize returns in this environment will primarily focus on dividend and earnings growth while keeping an eye out for bears on the horizon.

Risk aversion was the driver of positive investment performance in 2011 with the Barclay’s Bond Aggregate (the broadest fixed income index) returning 5.6%. The S&P 500 index returned 2.1% with dividend payments comprising the entire return for the year. The best performing sectors were Utilities (14.9%), Consumer Staples (10.5%) and Health Care (10.2%). There was a wide dispersion of sector performance in 2011 with Financials and Materials losing 18.4% and 11.6% respectively. Avoiding companies that employ leverage and have historically erratic earnings was the key to a better than average return for the year.1 (more…)

What is a risk-free rate debt instrument denominated in euros? Financial market participants are beginning to ask this question in earnest and are not happy with the answer: there isn’t one. Only the European Central Bank (ECB) has unlimited authority to create the European currency, not Greece, not France, not even Germany has that power. The result is that the specter of default has traveled from the periphery to the core nations of the European Monetary Union. Buyers of euro-denominated debt have been rethinking their purchases, as witnessed by the lack of demand for German bonds at auction last week. The solvency issue can only be resolved by the ECB (perhaps utilizing the IMF) stepping in as buyer of last resort for EU debt. It seems that enough pressure has mounted for Germany to concede the need for tighter fiscal union among the EU member nations and for a common debt instrument to be created that is backed by the unlimited resources of the ECB, but the political necessities of this arrangement will be very difficult to overcome in a timely manner.

Every day seems to bring about a new story on how the global economy is being undermined by the instability of a financial system that is more connected than any politician or regulator would like to admit. Last week, European leaders arranged for another round of funding for Greece and a 50% haircut for Greek bond holders. This week, MF Global filed for Chapter 11 bankruptcy protection after their highly leveraged proprietary positions in European debt went kaboom. While the Europeans are supplying the media with bold, 24-font headlines, corporate profits in the non-financial sector are up 15% year over year in the United States and GDP growth is accelerating. The disconnect between consumer confidence and consumer spending has been increasing since 2009 with spending rebounding strongly while confidence remains at all-time lows. Stock market returns have historically been inversely related to consumer confidence, returning double-digit average annual gains when confidence levels were similar to where they are today. Whether Greece stays in the EU or another highly-leveraged financial institution blows itself up is yet to be seen. But before you cash in your portfolio and run for the hills, take a look at what people and businesses are doing and not just what makes the front-page news.

The S&P 500 index turned in the worst quarterly performance in over two years, losing 13.9% in the third quarter.1 Materials and Financials were the worst performing sectors this quarter, losing 25% and 23% respectively. Stocks in those two sectors have now declined about 25% from the beginning of 2011 and account for the largest losses in the overall index so far this year. The defensive sectors in general and high-quality stocks specifically have held up relatively well as macroeconomic fears have come to dominate the investment landscape again this year.

Europe has reclaimed the spotlight in what seems to be a never ending experiment to try and extinguish a grease fire (pun intended) with a garden hose. Of course, using water to extinguish a grease fire only makes sense if you want to make the fire bigger. This is what we are witnessing in Europe as the ECB and political leaders of the various member nations repeatedly make their problems worse because they lack an understanding of how the system they designed was fundamentally flawed from inception. Greece, Portugal, Italy and Spain are all symptoms of an underlying problem and are not themselves the root cause, per se. The seeds of today’s financial problems in the EU were planted more than 10 years ago when the common currency of the Euro was created without an accompanying political union capable of supranational debt issuance, taxation and spending authority. The analogy would be the United States with all 50 states using the dollar, but with only a Federal Reserve and without any other branch of the Federal government. You would then have the governor of North Dakota chastising California for our profligate ways and lazy, tax-dodging citizens.

The popular press does not seem to understand monetary systems, as witnessed by the repeated comparisons of EU countries to countries that are sovereign in their own currency and have federal governments with the tools to regulate economic growth. The Economist is one of the most respected financial publications in the world, but even they get it wrong. In a recent article, they ponder why Japan has not been attacked by “bond market vigilantes” with more public debt as a percentage of GDP than Greece.

Why is there a widespread lack of understanding when it comes to monetary systems and how they operate? One would need to look at the evolution of modern monetary arrangements on a case by case basis and come up with a theory of how they are similar and how they differ. This has only been done by a small number of practitioners in the field of economics and finance and the theory of how modern monetary systems operate is relatively new. A concerted effort to understand the effects of changes in government policy within a framework of a given monetary system would undoubtedly lead to more effective solutions being implemented or considered and discussed as alternatives to the status quo.

The twin asset class bubbles in the United States of technology stocks (1996 – 2000) and residential real estate (1996 – 2006) continue to depress economic growth. Asset class bubbles are a semi-rare phenomenon, occurring when prices spike 2 or 3 standard deviations from the long-term trend in a relatively compressed amount of time. It does not take a special set of skills to detect an asset bubble. It is, by definition, a statistical anomaly that occurs globally every 40 years or so on average. The difficulty with asset class bubbles is not how to spot them, but what to do once they occur. If you are a professional investment organization, then the prudent course of action would be to avoid asset class bubbles at all cost, as they are the great destroyers of wealth for your clients. The difficulty with prudence is that it is universally unappreciated by clients until their accounts have been halved in short order by a less-prudent firm. (more…)